Construction Contracts
AS – 7
Contents
Ø Applicability & Nature
Ø Meaning of Construction Contracts
Ø Types of Contracts
Ø Contracts Revenue & Expenses
Ø Recognition Principles
Ø Para 22, 23
Ø Para 31, 35
Ø Disclosures
Ø Differences
Applicability & Nature
Applicable : 01-04-2001
Nature : Mandatory for Contractors only
Meaning of Construction Contracts
As per AS Construction means formation of asset or group of assets which are inter related. For example construction of Building, Dam, Bridges, Roads, or any other similar assets.
As per AS the following additional points should also be considered for the understanding of meaning of construction.
(i) If any agreement has been entered into between the parties for formation or demolition of old assets then such agreement should also be covered in the meaning of construction contract.
(ii) If any contract has been entered into between the parties in relation to formation of design & specification, then such agreement should also be recognized as Construction Contract.
(The main objective of AS is to distribute the total contract price over the life of contract on accrual basis.)
Types of Contract |
Fixed Price Contracts Cost Plus Contracts
Meaning of Fixed Price Contracts
Under Fixed Price Contracts, Price of Construction is decided between Contractor & Customer on the date of agreement. It means that selling price of contractor is fixed which is to be compared with actual cost & difference will be loss or profit of the contractor.
Meaning of Cost Plus Contract
If any situation of construction can’t be estimated by the contractor for the purpose of Fixed Price then Cost Plus Contract can take place under these contracts. Total cost is incurred by Contractor and Contractor receives a fixed percentage (%) of profit (Comm.) on the basis of cost incurred.
Contractor Profit = Total Cost Incurred x % of profit
There will be no loss to the contractor under Cost Plus Contract. (Recognition principles of AS are not applicable on Cost Plus Contract because objective of AS is to distribute total contract price over the life of contract and there is no contract price under these types of contract.)
Contract Revenue & Expenditure
Revenue:
Fixed Price Contract Cost Plus Contract
Contract Price xxx % of Profit on Cost xxx
Claims xxx Claims xxx
Incentive xxx Incentive xxx
Cost Escalation xxx Less: Penalties xxx
Less: Penalties xxx Total Revenue xxxTotal Revenue xxx
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Meaning of Claim
If any customer makes any default in providing necessary designs, guidance or other specification due to which extra cost is paid by contractor then such extra cost can be recovered by contractor from customer as per agreement. Such recovery of extra cost should be recognized as inflow for contractor in the name of claim.
Meaning of Incentive
If any customer has paid extra amount in addition to contract price for the performance of Contractor then extra payment should be recorded in the books of Contractor as additional inflow.
Meaning of Cost Escalation
It may be possible that prices of material & wages are expected to increase in future on the date of agreement. In such situation recovery of increased cost may be possible by cost escalation clause. The recovered cost should be recorded in the credit side of the P&L a\c as an income.
Penalties
Amount of penalties are decided between the penalties only to complete the work during specified period. If any delay in completion of work takes place the amount of penalty should be deducted out of contract price. Amount of penalty can be decided on per day basis, weak basis or month basis.
Contract Expenses
 |
Direct Expenses Common Expenses Specific Expenses
Direct Expenses
If any expenditure is directly related to a contract then amount of related expenses should be debited to the related contract. Direct expenses may include Direct material, Direct wages, Depreciation on plant, Hire charges for the plant or any other similar cost.
Common Expenses
If any expenditure is incurred by contractor on behalf of all the contracts then such common expenses should be divided between the contracts on some reasonable basis.
Specific Expenditure
If any expenditure is incurred by contractor as per the requirement of customer in relation to a particular contract then the required cost should be allocated to the related contract.
Recognition Principles
As per AS, Recognition Principles are based on existence or non-existence of ‘Outcome’. If Outcome is available, accounting should be made as per Para 22, 23 otherwise Para 31 will be applicable. The following conditions should be satisfied to prove the existence of Outcome.
(i) Contract price should be available.
(ii) Actual cost during the period should also be available.
(iii) Estimated cost to complete the contract should also be available.
(iv) Ultimate collection from customer should also be certain.
If any contractor is having existence of outcome, completion method can be applied for accounting purpose.
Step 1: First of all, % of completion of contract should be calculated.
% of Completion = Actual cost during the period X 100 Total Estimated Cost
Step 2: % of completion should be applied on total contract price for calculation of Revenue Recognition.
Revenue = Contract Price x % of Completion
Exception: There may be difference between calculated completion & physical completion. In such situation amount of revenue should be recognized as per Surveyor certificate.
If any company or contractor is not having required information for completion method then income should be recognized equal to expenses. In such case no profit or loss will be recognized.
Change in Estimation
As per AS total estimated cost or contract price can be changed over the construction period. In such situation, adjustments should be made on prospective basis as per provisions of AS – 5, Changes in Estimates.
Ques 1 Contract Price = 900 Cr
Other information
I II III
Actual Cost during
the period (Cumulative) 161 574 820
Total Estimated Cost 805 820 -
Increase in Contract
Price - 20 -
Calculate Amount of Profit or Loss over construction period assuming that contract is completed in 3rd year.
Sol: Period I
W.N. Calculation of % of completion
% of Completion = 161 Cr / 805 Cr
Income Recognition (Profit/Loss)
Contract Price (900 x 20%) = 180 Cr
Less: Expense = 161 Cr
19 Cr
Period II
% of Completion = 574/820 X 100 = 70%
Income Recognition (Profit/Loss)
Contract Price (920 x 70%-180) = 464 Cr
Less: Exp of Current Year (574-161) = 413 Cr
51 Cr
Period III
Contract Price = 920 Cr
Less: Total Contract Price
(Already recognized) = 644 Cr
276 Cr
Less: Exp of 3rd year (820-574) = 246 Cr
30 Cr
Disclosures
(i) Accounting policies should be disclosed separately
(ii) Classification of contract under the heading of fixed price and cost plus contracts should also be made separately.
(iii) As per AS difference between actual sale & billing amount should be disclosed separately in Balance sheet.
(iv) Difference between billed and cash received should also be disclosed separately. (Such difference can also be recognized as retention money)
Ques 2 Contract Price = 5 Lakh
Additional information (in Lakh)
I II III
Cumulative cost (actual) 1.50 3.60 4.05
Estimated Cost (further) 3.00 0.40 -
Billed Amount 1.00 3.70 0.30
(Respective)
Collection Amount 0.75 3.00 1.25
(Respective)
Calculate amount of profit / loss over the construction period and also calculate relevant disclosures as per the requirements of AS – 7.
Sol:
W.N.1 Calculation of % of Completion of Contract
I II III
Actual Cost 1.50 3.60 4.05
Total Estimated Cost 4.50 4.00 -
% of Completion 33.33% 90% 100%
W.N. 2 Calculation of Contract Revenue to be Recognized
I II III
Contract Price 5.00 5.00 5.00
% of Completion 33.33% 90% 100%
Contract Revenue 1.66 4.50 5.00
Less: Previous Revenue - 1.66 4.50 Net Contract Revenue 1.66 2.84 0.50
Statement of Profit / Loss
I II III
Contract Revenue 1.66 2.84 0.50
Less: Expenses 1.50 2.10 0.45
Profit / Loss 0.16 0.74 0.05
Statement showing Retention Money
I II III
Amount Billed 1.00 3.70 0.30
Less: Collection 0.75 3.00 1.25
Retention Money 0.25 0.70 0.95
Comment: In the Balance Sheet of 1st year & 2nd year Retention money should be disclosed of Rs. 25,000 & Rs. 95,000
Statement showing Difference in Sales (Cumulative)
I II III
Sales (AS – 7) 1.66 4.50 5.00
Less: Amount Billed 1.00 4.70 5.00
Difference 0.66 (0.20) 0.00
Note: As per AS difference in sale should be calculated on cumulative basis because adjustment of period wise information will be made automatically.
Ques 3
Projects X Y
Contract Price 6 Lakh 8 Lakh
Date of Contract 01-04-05 01-04-05
Additional Information
(i) Completion period for Project X has been decided between the parties of 2 yrs. (Completion date 31-03-07 ).
(ii) To complete the project X during the decided time, there is a provision of penalty of Rs. 10,000 per day.
(iii) Completion time for project Y has been decided of 3 yrs.
(iv) Cost information
X Y
Period I
Actual Cost 3.60 Lakh 4.10 Lakh
(Further) Estimated Cost 0.40 Lakh 4.10 Lakh
Period II
Actual Cost (Cumulative) 4.50 Lakh 7.20 Lakh
(Further) Estimated Cost - 1.80 Lakh
Calculate amount of profit/loss for project X and Y for the 2 different periods assuming that Project X is completed by the contractor in time but actual possession is given after 4 days.
Sol: Calculation of Profit / Loss of Project X
I II
Actual Cost (Cumulative) 3.60 Lakh 4.50 Lakh
Add: Estimated 0.40 Lakh -
4.00 Lakh 4.50 Lakh
% of Completion 90% 100 %
Statement of Profit / Loss
I II
Contract Price 6.00 Lakh 6.00 Lakh
Less: Penalty Amount
(10000 X 4) - 0.40 Lakh
Less: Previous Recognition - 5.40 Lakh
6.00 Lakh 0.20 Lakh
% of Completion 90% 100 %
Income Recognition 5.40 Lakh 0.20 Lakh
Less: Expense (Respective) 3.60 Lakh 0.90 Lakh
Profit / Loss 1.80 Lakh (0.70 Lakh)
Project Y
As per AS provision should be created if total estimated cost is higher than contract price. In the given situation total estimation is higher than contract price.
Statement of Expected Cost
I II
Contract Price 8.00 Lakh 8.00 Lakh
Total Estimated Cost 8.20 Lakh 9.00 Lakh
Provision Required 0.20 Lakh 1.00 Lakh
Additional Provision is of Rs. 80,000/-
Difference between AS/IAS/US GAAP:
As per AS – 7, Completion Method is specified for accounting purpose. In other statement completed method is also specified for accounting of contract. Under completed method income can be recognized only if contract is completed by the contractor at the end of completion period.
Working Notes
(i) Calculation of Specific borrowing cost
Interest on 10 % Term Loan = 200 x 10/100 = 15 Lakh
Add : - Related Expenses = 2 Lakh
17 Lakh
(ii) Calculation of General borrowing cost
Interest on 15 % Debentures = 400 x 15/100 = 60 Lakh
Interest on 12 % Term Loan = 300 x 15/100 x 2/12 = 6 Lakh
Add : - Related Expenses (1 Lakh + 2.5 Lakh) = 3.50 Lakh
69.50 Lakh
Treatment of Borrowing Cost
Specific Borrowing Cost: - Borrowing cost of Rs. 17 Lakh should be capitalized to the cost of plant & machinery because 10 % Term Loan is directly related with Plant & Machinery.
General Borrowing Cost: - As per AS – 16, General Borrowing cost should be allocated over qualifying assets in the ratio of expenditure. For the application for such provisions the following Statement will be considered.
Statement showing allocation of general Borrowing Cost
Factory Shed 100 Lakh 1/9 7.72 Lakh
Plant 700 Lakh (900-200) 7/9 54.05 Lakh
Other Fixed Assets 100 Lakh 1/9 7.72 Lakh
69.50 Lakh
Ques 9
(i) In the given question, amount of general borrowing cost is higher than expenditure incurred on qualifying asset. So full capitalization will not be allowed but proportionate capitalization according to the expenditure should be made.
(ii) General Borrowing cost related to unused borrowed funds should be transferred to P&L A/c.
Working Note
Statement showing calculation of General Borrowing Cost
Total General Borrowing Cost = 28 Lakh + 36 Lakh = 64 Lakh
(a) General Borrowing Cost related to expenditure = 64 Lakh x 400 / 500 = 57.20 Lakh
(b) General Borrowing Cost related to unused amount = 64 Lakh x 100 / 500 = 12.80 Lakh
Capital A/c = Part (a)
P&L A/c = Part (b)
Statement showing allocation of G.B. Cost
Plant 200 Lakh 25.60 Lakh
Internal Road 100 Lakh 12.80 Lakh
Plant II 100 Lakh 12.80 Lakh
400 Lakh 51.20 Lakh
Comment: - Borrowing cost related to 16% Secured Loan should be capitalized directly to the cost of factory building.
Ques 10
As per AS – 16, Qualifying Asset are those assets which are related to substantial period of time for their completion for the purpose of use of sale. On the basis of such explanation, Inventories can also be covered in the definition of Qualifying Assets. In addition it is also considerable that such inventories should take substantial period of time to get ready for the purpose of sale.
In the given situation, the sugar company has already produced sugar and the specified items are ready for sale. So the produced inventories can’t be covered in the meaning of Q.A.
As per the provisions of AS – 16, Interest can be capitalized only if it is related with expenditure on Q.A. So the company can’t capitalize to the cost of inventories because the provision of AS – 16, are not applicable on the given situation.
Ques 13
Statement showing Calculation of cost of Asset
Period Op. WIP New Exp Amount of Loans B. Cost Cl. WIP
I ---- 100 Lakh 60 Lakh 7.20 Lakh 107.20 Lakh
II 107.20 Lakh 100 Lakh 120 Lakh 14.40 Lakh 221.60 Lakh
III 221.60 Lakh 80 Lakh 160 Lakh 19.20 Lakh 320.80 Lakh
IV 320.80 Lakh 60 Lakh 200 Lakh 24.00 Lakh 404.80 Lakh
V 404.80 Lakh 50 Lakh 230 Lakh 26.00 Lakh 482.40 Lakh
Assumption: - In the given ques, date of borrowing is not specified. So we have assumed that borrowings are made by enterprise in the beginning of year.
Ques 1
W.N.1
(i) Calculation of expenditure incurred till 31-03-2001
Op. WIP (450 Lakh + 24 Lakh) on 01-04-2000 = 474 Lakh
Add: Expenditure during the Period
In Cash 78 Lakh
In Asset 100 Lakh
Less: Progress payment Received (300 Lakh)
Total Cost 352 Lakh
(ii) Statement showing Capitalization of Borrowing cost
Expenditure incurred till 31-03-2001 = 352 Lakh
Total Borrowing till 31-03-2001 = 400 Lakh
Total Borrowing cost (400 x 12 %) = 48 Lakh
Capitalization of Borrowing Cost = 48 x 352/400 = 42.24 Lakh
Expenses of Borrowing Cost = 48 x 48/400 = 5.76 Lakh
Notes
(i) As per the provisions of AS – 16, if any progress payment or Govt grants is recognized by the enterprises during the period then the recognized amount should be deducted out of expenditure incurred.
(ii) In the given question date of progress payment is not specified. So we have assumed that date of progress payment is the first day of financial year.
(iii) In the given question, interest of current year is clearly specified of Rs. 48 Lakh. Such amount is calculated on the amount of borrowing of Rs. 400 Lakh @ 12%. It means that interest of previous year has already been paid and not included in the amount of borrowings. So assumptions of outstanding interest will be totally incorrect.
Ques 4
In the given example, there are multiple assets which are purchased out of single borrowed fund. It means that situation will be covered under the heading of General Borrowing and ratio of expenditure should be applied for the allocation of General Borrowing Cost.
Statement showing Allocation of General Borrowing Cost
Building 120 Lakh 10.80 Lakh
Plant 350 Lakh 31.50 Lakh
Capital WIP 70 Lakh 6.30 Lakh
Working Capital 110 Lakh 9.90 Lakh
650 Lakh
Treatment: -
(a) Interest of Rs. 10.80 Lakh and 31.50 Lakh should be capitalized in the cost of building and plant respectively. Because these assets are ready for use at the end of the year.
(b) Interest of Rs. 6.30 Lakh should be also be capitalized in the name of Capital WIP because advance payment for installation of plant has been made and it can be assumed that administrative activities which are required to complete have been in progress.
(c) Working capital is not qualifying asset so interest related to working capital should be transferred to P&L a/c.
Note: Wherever in any ques there is difference in the amount of expenditure as well as period of progress then gross borrowing cost should not be allocated in the ratio of expenditure but the following steps should be applied.
Step1:
First of all average capitalization rate should be calculated on average basis.
Capitalization rate = Total Borrowing cost X 100
Total used amount during the period Step 2:
After calculation of capitalization rate, such rate should be applied on the expenditure of qualifying assets directly with reference to period of construction or progress.
Ques 14
W.N.1 Calculation of Capitalization rate
Total used amount during the period
18% Bank Loan = 1000 x 12/12 = 1000
14% Debenture = 2000 x 6/12 = 1000
16% Term Loan = 3000 x 9/12 = 2250
4250
|
Capitalization Rate = 180 + 140 +360 X 100 |
4250
Statement showing allocation of Gross Borrowing Cost
Factory Shed 2500 x 16% x 12/12 = 400.00
Plant I 1500 x 16% x 9/12 = 180.00
Plant II 1000 x 16% x 7/12 = 93.33
Total Capitalized Cost 673.33 |
Comment:
Total Borrowing cost is of Rs. 680 but cost can be capitalized to the extent of Rs. 673.33 as per above statement. Difference between total cost and capitalized amount should be transferred to P&L a/c because expenditure is lower than total borrowings.
Disclosures: (Notes to Account)
1. Accounting policy should be disclosed separately.
2. Amount of borrowing cost which is capitalized during the period should be disclosed separately.
Difference between AS – 16, IAS – 23 and US
Difference between the three Statement is not important because such difference is not related to accounting of borrowing cost but it is related to disclosure only.
1. As per IAS – 23, amount of interest expense which is capitalized or not capitalized during the period should be disclosed separately.
2. As per US GAAP – 34, amount of capitalization is not required but capitalization rate should be disclosed separately.
3. As per AS – 16, if any interest cost is not capitalized during the period then no disclosure will be required. It means that disclosure requirements are applicable only if capitalization of borrowing cost has been made during the period.
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